Army generals are a mostly pliant lot. To reach to the top of the military chain of command it is advisable to follow orders from above without asking too many questions. This helps explain why presidents in Latin America prefer to entrust the running of state-owned enterprises to retired generals – they are not likely to overthink ukases and can be expected to do as told.

Late February, President Jair Bolsonaro of Brazil ousted Petrobras CEO Roberto Castello Branco over his refusal to scrap petrol and diesel price increases. Incensed at Mr Castello Branco’s insubordination, President Bolsonaro refused to renew the executive’s contract and announced his replacement by retired general Joaquim Silva e Luna who is to be transferred from the Itaipú hydro power plant. Immediately after his appointment, the 71-year-old hinted that he would suspend the policy of setting domestic fuel prices in line with international levels.

The last time Petrobras was forced to keep the price of petrol and diesel artificially low, the company bled about $40 billion over a four-year period which saw its debt balloon to $126 billion. During the 13-year rule of the Workers’ Party (2003-20016), Brazil’s largest company initially managed to keep its nominal independence, making great strides towards increasing production and gaining worldwide recognition as a pioneer of deep-water oil recovery techniques.

Crawling Out of a Hole

After surviving, albeit barely, the rather disastrous last four years of Workers’ Party rule, Petrobras managed to extract itself from corruption affairs and political meddling to rebuild its much-tarnished reputation. Under Mr Castello Branco, the company slowly regained the trust of its investors and partners by returning to profitability. In 2019, Petrobras recorded a $10 billion profit on $76 billion in revenue. Four years earlier, the company lost $8.5 billion on a $97 billion turnover. Mr Castello Branco also managed to reduce the corporate debt load to $63 billion.

Investors were shocked at the CEO’s unceremonious dismissal and promptly dumped Petrobras shares which tumbled just over 20% in a single trading day. Some 73% of Petrobras shares are publicly traded though the Brazilian government holds 50.5% of voting rights. Fitch Ratings immediately warned of a possible cashflow crunch, should fuel prices be capped.

Analysts point to the significant investments required to tap into Brazil’s lucrative pre-salt basins that produce an exceptionally light crude. Market watchers are also concerned that the proposed sale of Petrobras’ secondary assets such as pipelines and refineries could suffer delays should the company spook interested buyers with a lack of predictability.

The shake-up at Petrobras has, however, much wider implications than just for the oil company. Investors and market watchers fear that the mercurial hard-right president may be offloading his free market credentials – always a bit iffy and more the product of wishful thinking than actual accomplishments – for political expediency. In January, President Bolsonaro let it slip that the country is effectively broke: “There is nothing I can do,” he admitted bluntly before contemplating a new stimulus package.

Last year, the Corona Pandemic shaved about 5% off Brazil’s GDP, considerably less than was lost in most neighbouring countries. The Bolsonaro Administration spent an estimated eight percent of GDP on support and stimulus packages. Public debt rose to well over ninety percent of the national output – the highest debt of any major developing economy apart from China. However, the International Monetary Fund (IMF) does expect the economy to bounce back with 2021 growth forecast of 3.6%. The expected arrival of a minor commodities boom may offer additional solace.

Spending Feast

The end of monthly cash handouts – $9 billion in monthly ‘corona vouchers’ of $110 each reaching about a third of the population – and other stimulus benefits may hit the informal economy hardest with private demand unlikely to pick up the slack. Seen in this light, the IMF growth prediction seems a bit optimistic.

President Bolsonaro must now find a way around the 2016 spending cap imposed by congress which limits the size of the federal budget to the level of the previous year, corrected for inflation. Investors fear that any attempt at removing this ceiling via a constitutional amendment may well spark a major crisis should investors lose confidence in the government’s ability to meet its, mostly domestic, debt obligations.

Complicating the picture yet further, next year’s polls may also tempt President Bolsonaro to throw caution to the wind and spend his way to a second term in office. The administration’s stalled fiscal reform agenda has investors wary. Meaningful fiscal reform, promised by successive governments for the past thirty-odd year, has yet to materialise. The administrative reforms promised last year by Finance Minister Paulo Guedes, and slated to shave $57 billion off the budget over a decade, have also not been implemented.

Looking at Brazil, foreign investors mostly see a complex and unfriendly business environment that includes high taxation and a considerable infrastructure deficit resulting in high energy and logistic costs.

Meanwhile Minister Guedes, a disciple of Milton Friedman with impeccable free market credentials, has been relegated to the political background, disappearing from public view for days on end since last December when he clashed with Central Bank President Roberto Campos Neto. The banker had demanded the government president a ‘credible plan’ to stabilise public finances. Mr Campos Neto objected to the ‘extravagant’ spending on corona relief. Brazil has outspent most emerging market economies on support measures.

A sign of trouble ahead can be gleaned from the steepening yield curve of domestic debt with the ten-year bond currently generating 7.4% whilst the central bank’s benchmark interest rate stands at 2%. In an attempt to invert the yield curve, the government is massively issuing short-term paper. Average maturities on domestic federal debt are down to just 3.5 years. Over the second quarter, a volume of debt equal to six percent of GDP must be rolled over, offering the market a chance to display its sentiment.

Where to Next?

In line with other emerging markets struggling to keep their economy growing at a clip that promises deliverance from underdevelopment and poverty, the roadblock to riches in Brazil is – as ever – politics. Far from a free market champion, the Bolsonaro Administration is as populist as most of its predecessors, if not more so.

The recent Petrobras episode illustrates that the president prefers political expediency if given a choice. Investors are rightfully concerned that Mr Bolsonaro’s choices may yet end up in tears. Optics deceive: Finance Minister Guedes – the darling of investors – undoubtedly knows what is best but has apparently been deprived of his tsar-like powers. The president – a former military man – now calls the shots.

Cover photo: President Jair Bolsonaro of Brazil.

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© 2016 Photo by Agência Brasil